Top trends in mutual fund investing

Dan Kadlec, Special to CNBC.com

Wednesday, 15 Jan 2014 | 8:00 AM ETCNBC.com

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Jay Brousseau | The Image Bank | Getty Images

Investors rediscovered the stock market last year, reversing five years of little or no flows into stock funds and enjoying the headiest gains since the Internet bubble. Most experts predict the migration into stocks will continue and stocks will keep rising, though few expect anything close to a repeat of the S&P 500's 2013 total return of 32 percent—one of the best annual gains in history.

The flood into stocks started 12 months ago as income-starved individuals wearied of low bond yields and poured money from savings into dividend-paying blue chips. When interest rates jumped in May and bond prices fell, it triggered a further exodus from bond funds, and many of the proceeds also shifted to stocks.

Nothing stemmed the movement for long—not historical levels of political dysfunction and uncertainty, or the Fed signaling it would wind down a massive bond-buying program. In all, investors poured $437 billion into stock funds, including ETFs, while fleeing fixed income, according to data from fund research firm Lipper. The shift paid off: The average U.S. diversified large-cap stock fund matched the S&P 500 gain, while bond funds, which had performed well in recent years, fell an average 2 percent.

The move into stocks was broad-based, but it was not indiscriminate. A lingering fear of sudden market downdrafts, such as that in 2008, and of an aging population that cannot count on outlasting another market cycle before retirement, shaped much of the reversal. Simply put, many no longer see stocks for the long run as a viable strategy; they have been searching for more income, but with safety. This approach is driving five investing trends that promise to remain with us through 2014 and longer.

Going global

Fund investors used to construct their portfolio focusing on large- and small-cap U.S. stocks in various categories like growth or value, adding a dollop of international stocks for diversification and rounding it out with U.S. bonds and some cash. This home-based approach has fallen out of favor since the financial crisis, which struck so hard in many developed economies but less so elsewhere. Investors now want the safety of more global exposure.

"Diversity was defined very differently five years ago," said Robert Martorana, portfolio manager at Right Blend Investing. Americans still have 50 to 70 percent of their portfolio in home-based assets. Financial advisors are moving clients closer to 40 percent. This likely will be a decade-long process, Martorana said, and is perhaps most evident in the cash flowing into developed international market funds. Such funds saw inflows last year of $152.5 billion, about a third of all money going to stock funds.

Favoring brand-name funds

As the investment climate turned hostile in the wake of the financial crisis, investors increasingly sought the security of brand-name mega mutual funds. Three decades ago there were just a handful of popular mega funds, including Fidelity Magellan, Janus and Vanguard 500 Index—all large-cap and growth-oriented. Today there are one or two big go-to funds in every category, and they are sucking up most of the assets. For example, Lipper data show that the two largest developed international markets funds last year gathered 19 percent of all cash flowing into the group; the 10 largest claimed half of the inflows.

"People want something they know," said Martorana. "When they feel confused, they go with the big brand." It's not about chasing returns, but a comfort level with the manager and strategy. The Mainstay Marketfield fund, run by Michael Aronstein, returned just 16.9 percent—not much more than half the S&P 500 gain. But it is a category killer among long-short funds that seek to minimize downside risk. Mainstay saw net inflows of $10.3 billion, nearly tripling its assets under management.

Blockbuster funds vacuuming up assets in other categories include Oakmark International, a broad-based stock fund with net inflows last year of $12.2 billion, which boosted assets 77 percent to $28 billion; and Oppenheimer Senior Floating Rate, a bank loan participation fund with net inflows of $3.8 billion, which boosted assets 115 percent to $7.1 billion.

A Gangbuster Year for Returns

In 2013 investors moved into stocks and got a big payoff.

Fund Macro-Classifications

1-Year Total Return (%)

Small-Cap Funds

38.55

Large-Cap Funds

32.45

Alternative Funds

8.12

World Taxable Fixed Income Funds

-4.48

Long-Term Taxable Bond Funds

1.94

All Funds Average Return

15.15

S&P 500 Daily Reinvested Total Return Index

32.39

Barclay U.S. Aggregate Total Return Index

-2.02

Source: Lipper, a Thompson Reuters company

Finding Alternatives

The flows into such category-killer funds point up another trend: the growth of mutual funds with little correlation to market benchmarks. Called alternatives, these hedge fund–type investments last year saw the biggest percentage inflows of any fund group as investors reached for strategies that promised limited downside, low volatility and positive returns even in a market that stalls or falls. Such funds may employ long-short strategies, while others—like risk arbitrage, commodities futures and global macro economic—bets around things like interest rates and currencies.

"These hedging strategies are popular with people over 55 and who want to manage their downside," says Robert Jenkins, global head of research at Lipper. The category saw inflows of $51.7 billion, boosting assets 41 percent to $178.6 billion. Financial advisors increasingly embrace these funds for pre-retirees, who don't need to beat a benchmark but must earn something before they call it quits. Investors in these funds have been willing to pay fees about a half point higher than on traditional funds, valuing more certain, if less robust, gains.

This trend lies behind the near tripling of assets at Mainstay and large inflows at other alternative funds, including AQR Managed Futures, which plays in commodities and other securities and saw net inflows of $2 billion, boosting assets 60 percent to $4.5 billion; and GMO Benchmark Free, an absolute return fund that saw inflows of $1.7 billion, boosting assets 155 percent to $2.8 billion.

Where the Money Went

On a percentage basis alternative funds were the clear winners in 2014.

Macro-Classifications

2013 Estimated Net Flows ($Mil)

YE 2012 TNAs ($Mil)

Estimated Net Flows as a % change from 2012 YE TNA

Alternatives Funds

51,672.1

126,928.7

40.71%

Sector Equity Funds

58,671.3

348,050.2

16.86%

Developed International Markets Funds

148,234.9

1,286,319.7

11.52%

U.S. Diversified Equity Funds

60,363.8

803,933.7

7.51%

Mixed-Assets Funds

94,209.7

1,597,122.2

5.90%

Small-Cap Funds

23,545.7

404,482.7

5.89%

Mid-Cap Funds

18,430.7

404,882.7

4.55%

Emerging Markets Funds

17,367.4

425,775.8

4.08%

World Sector Equity Funds

4,230.6

116,845.2

3.62%

Multi-Cap Funds

13,963.4

895,449.4

1.56%

Money Market Funds

33,997.2

2,312,549.4

1.47%

Long-Term Taxable Bond Funds

-3,781.3

1,346,218.9

-0.28%

Large-Cap Funds

-21,345.9

1,407,818.2

-1.52%

World Taxable Fixed Income Funds

-5,265.1

259,138.4

-2.08%

Short-/Intermediate-Term Bond Funds

-27,967.9

1,108,237.9

-2.52%

Short-/Intermediate-Term Municipal Debt Funds

-10,441.7

250,446.3

-4.17%

Tax-Exempt Money Market Funds

-17,750.3

285,666.6

-6.21%

Long-Term Municpal Debt Funds

-48,197.9

346,004.7

-13.93%

Commodities Funds

-32,316.6

169,190.9

-19.10%

Grand Total

357,619.9

13,893,061.6

2.57%

Source: Lipper, a Thompson Reuters company

Searching for income

Low interest rates have led investors to all manner of income-producing investments: dividend paying stocks, municipal bonds, corporate junk bonds, foreign debt and much more. But you can't just gobble up income across the globe and across the credit spectrum and call it diversification. Emerging markets debt and junk bonds have a high correlation to U.S. equities. Meanwhile, with rates set to rise long-term, government debt continues to look especially risky. So there has been a push into things like bank participation funds, short-term bond funds and, perhaps most notably, global macro funds that hunt for special situations around the world.

"It makes a lot of sense to go out there and try to find special opportunities in fixed income," said Jenkins. "Unconstrained bond funds can get at them a lot easier than benchmark products." This helps explain why Pimco Unconstrained, a global macro fund, saw inflows last year of $7.3 billion even though star manager Bill Gross's fund fell 2.2 percent in a tough climate for fixed income. Other alternative-income funds delivered: Oppenheimer's Senior Floating Rate fund and the Goldman Sachs Strategic Income fund, both among the biggest, returned more than 6 percent.

Again, fees may be a half point higher for these types of funds. But this investing is labor intensive, wrapping in securities like master limited partnerships and bank loans and assessing global economic trends and individual-issuer credit quality.

Flocking to ETFs

Exchange Traded Funds have been on a growth tear for more than a decade; assets in these funds have grown from almost nothing at the turn of the century to $1.3 trillion. The rise of ETFs continued through the recession with inflows of around $100 billion a year, and the pace quickened more recently as investors came back to stocks.

Net inflows last year came to $151.3 billion on top of $155 billion in 2012, the biggest two years of inflows in this group since the meltdown. Much of the action was in the biggest ETFs. The $175 billion SPDR S&P 500 Trust had inflows of $15.3 billion.

"ETFs are transparent, tactical and tax effective," said Martorana. "People like to invest this way." He believes assets will continue to flow to ETFs from traditional open-end mutual funds for years to come. A popular approach is to use ETFs for broad low-cost exposure to the markets and then tack on alternatives to limit your downside. After all, today's fund investors value safety above the potential to beat the market.